Understanding Market Cycles: Risks & Opportunities

Market cycles, as the term suggests, happen again and again over time, and they cover a wide range of types: bear markets and bull markets, sell-offs and rallies, and expansions, recessions, and recoveries. These cycles come in different shapes, sizes, and durations, and no two are exactly alike.

By understanding the various definitions of market cycles, learning how to identify them, and seeing how they've played out over time, investors can potentially gain valuable insight for portfolio strategy.

In general, cycles refer to the idea that markets—including stock prices—go through a process of ups and downs and buying and selling amid shifting beliefs and opinions over valuations for equities and other assets. Investors can use knowledge of market cycles to inform their decisions, but there are a few important things to know.

Names are often assigned to market cycles. A bull market is a long-term uptrend marked by optimism and a robust economy. By contrast, a bear market is a prolonged downtrend, usually marked by declines of 20% from recent highs, accompanied by widespread negative sentiment. The record bull run in U.S. stocks, which began in early 2009 and ended in March 2020, is a recent example of a long-term market cycle.

Long-term cycles can also include several shorter cycles. For example, within a long-term cycle, there might be short-term sell-offs that didn't turn into bear markets or periods of largely sideways price movement. As illustrated in the chart below, investors can reference a monthly chart of a benchmark like the S&P 500^® index (SPX) for the past 20 years to identify previous long-term market cycles.

Market cycles are usually marked by fluctuating prices as buyers and sellers come to an agreement over price and valuation of various assets. As cycles unfold and investor enthusiasm ebbs and flows, asset valuations can move from "fair," to elevated or overvalued, to undervalued or cheap, and all points in between.

Market cycles are also heavily influenced by real-world events, such as elections, economic trends, wars, pandemics, and more.

Additionally, market cycles can be closely tied to business and economic cycles. As the economy picks up, equity markets often do too. In some cases, market sentiment may even rise ahead of increased economic activity. As investor enthusiasm and sentiment increases, equity valuations often increase as well. As a rally extends, valuations might become elevated. If economic indicators become even stronger, the markets may actually begin to decline in anticipation of monetary policy changes designed to prevent overheating. An economic slump or recession can end one market cycle and start another.

Identifying the four stock market cycle stages can help investors make more informed portfolio strategy decisions. The four market cycle stages are:

• Accumulation. This stage is characterized by meandering, sideways price action that stays within a range and can potentially last a long time in individual stocks, sectors, or the market as a whole.
• Markup. In the markup stage, prices often "break out" above chart resistance levels and are accompanied by spikes in trading volume as individuals and institutions start clambering on board.
• Distribution. This is a "topping" stage for a stock, sector, or broader market, often signaling a "rotation" as early buyers—those who bought during the accumulation stage—begin to sell.
• Markdown (or decline). During this stage, prices fall and remain relatively low. With many institutional players having sold stocks, there may be few new buyers to absorb greater selling. Downward momentum accelerates.

Emotions can also influence market cycles. Fear, in particular, plays a big role at both ends of a market cycle. There's fear of "missing out" on a rally and fear of "losing it all." For example, during a market slump, continuing price declines can lead to negative emotions among retail and institutional investors, sometimes leading to panic selling.

For investors, selling during a downturn can have consequences, especially if they leave the market entirely. For index investors, staying in the market can potentially lead to gains over time. Additionally, by understanding a downcycle is usually followed by an upcycle, an investor is less likely to miss out on receiving gains during the best days of the market cycle.

After closing at a record 3,386.15 on February 18, 2020, the SPX took about 16 trading days to tumble 20% into official bear market territory and fell as much as 34% before it began its recovery.

In today's technology-driven media and market environment, with information circulating faster and faster, market cycles tend to compress. Millions of investors are tuned in to markets every day through the internet and mobile devices. Plus, for retail investors, the traditional barriers to rapid trading—including commissions—have mostly been eliminated. For some investors and traders, commissions were a mental speed bump in the past.

Investors who can separate their emotions from investing decisions and strategy can approach their trading from a more objective perspective.

Markets can swing suddenly and unexpectedly and go through elevated volatility. Investors who understand their personal risk tolerance and use a historical perspective when evaluating the markets can potentially make more informed decisions about their long-term portfolio strategy.

By considering possible scenarios and outcomes as well as certain triggers like price targets, investors can look at their trading approach from a more holistic perspective that's based more on historical data and less on emotional bias. For example, an investor could identify a price target for a certain stock that is a certain percentage above or below where it was bought, then create an alert or auto order in advance. This can trigger a stop order, or it can result in an auto-buy if an asset reaches an attractive price during a downcycle. By incorporating market cycles in a portfolio strategy, even if it's staying the course during a major event, it's possible for investors to potentially profit.